MARKET RISK MANAGEMENT

DEFINITION OF MARKET RISK

The exposure to potential loss that would result from changes in market
prices or rates

TYPES OF MARKET RISK

1. Liquidity Risk; risk of insufficient fund for current and due
obligations, either by increasing liabilities or converting assets
without incurring significant losses
2. Trading risk
3. Asset/Liability risk; different sensitivities of assets and liabilities

Interest rate risk

Foreign exchange risk
Commodity risk
Basis risk
Equity risk

Market Risk Measurement

GAP ANALYSIS Group assets and liabilities according to when

they will be re-priced. The difference between
them is known as the gap
A negative gap would indicate a risk exposure
to increasing rates
DURATION Determines price sensitivity to changes in
interest rates
Takes only into account parallel shifts in
interest rates
VALUE-AT-RISK Measure of the likely loss of market value for a
given portfolio over a predetermined
confidence level and holding period

VaR is calculated as the product of three basic

factors:
1. Exposure amount, the size of open position at
risk
2. Price volatility
3. Liquidity factor

Three main approaches in calculating VaR

 1. Parametric (variance-covariance approach)
o Changes in risk factor: normally distributed
o The change in value of portfolio resulting
from a change in risk factor: linear
o Advantages: simplifies calculation
o Disadvantages: not suitable for options
embedded, and simplification is not always
true
2. Monte-Carlo simulations
Changes in risk factor: Normally distributed
The change in value of portfolio resulting from
a change in risk factor: Non-linear
Advantages: suitable for non-linear relationship
of portfolio and risk factor
3. Historical simulation
Changes in risk factor: Historical
The change in value of portfolio resulting from
a change in risk factor: Non-linear
Advantages: most suitable to real economic
environment
Disadvantages: Limited only to the information
caught from the data

Difference in the three can be used to calculate

the non-linearity and non-normality

ESTIMATING THE Stress Testing; bottom-up approach, based on

MARKET RISK OF shocks to key risk factors
EXTREME EVENTS 1. Determine which variable to be stressed and to
what levels
2. Develop how it affect the prices within portfolio
3. Measure the impact of the stress test on
portfolio
4. Develop alternative strategy to implement
5. Evaluate cost benefit analysis to the strategy

Scenario Analysis; top down approach; define an

alternative state of the world and draw out the
implications to portfolio value. To understand the
impact of unlikely but catastrophic events
1. Defining scenario
2. Understand what relevant risks related to the
scenario and the magnitude of it
3. Define early warnings systems, specific action
plans and hedging strategies
4. Reviewing the scenario periodically to see if it
needs to be modified
VERIFYING
THE To evaluate the accuracy of risk analysis by
MEASUREMENT : comparing results to historical experience, testing
BACK TESTING for:
1. Software and database
2. Modeled P&L vs actual P&L
3. Whether modeled probability distribution is
consistent with experience

Should be able to have explanations for any

differences

Market Risk Management

POLICIES Documentation will ensure that all market risks

are identified, measured, monitored, controlled,
and regularly reported to senior management or
board of directors

Benefits of market risk management policies:

1. It facilitates a discussion of important issues
with market risk
2. A clear layout how risk management will be
performed within the company

Risk management policies should cover for:

1. Roles and responsibilities
Organizational and reporting lines
2. Delegation of authority and limits
Who is permitted to execute market risk
positions for the company
3. Risk measurement and reporting
o To ensure consistency with limits, metrics,
methodologies, and assumptions
o Reporting and escalation procedures
(include immediate escalation)
4. Valuation and back-testing
How they are mark to market or mark to model
5. Hedging policy
Defines the type of risks that are to be hedged,
the target risk levels, and the products and
strategies that can be used
6. Liquidity policy
o What measurements are used to monitor
liquidity
o Establish target liquidity position
o Establish contingency plan
7. Exception management to accommodate
customer request
LIMITS
REPORTING
ECONOMIC CAPITAL
REQUIREMENT
PORTFOLIO
STRATEGIES

Best Practices for Market Risk Management

BASIC PRACTICE
At most basic, they evaluate the earnings impact of various market risk
factors.
Use of simple tools like gap analysis, and market models from spreadsheet
or basic vendor models
Basic function is mainly a policy, analysis, and reporting function
Performance of market function is dependent on its policy development,
reporting effectiveness, and analytical skills with respect to earnings
volatility assumption

STANDARD PRACTICE
More robust modelling capabilities, including VaR, earnings, earnings and
equity value sensitivity analysis, and simulation capabilities.
Manages the balance sheet more actively, but its mandate is not to
maximize profit.
Performance of market function is rimarily determined by compliance with
policy risk limits, and secondarily by the earnings derived from the market
risk book.

BEST PRACTICE
Both corporate control function and a full fledged profit center.
As control center to ensure that market prices and rates do not result in
excessive losses.
As profit center to maximize profit within the risk limit established by the
corporate control function.
Use of advanced risk management tools include:
Hot spot analysis
Best hedge analysis
Best replicating portfolios
Implied view